The Impact of Paying Interest on Reserves in the Presence of Government Deficit Financing
This paper re-examines the impact that paying interest on reserves has on price level indeterminacy, price level volatility, and overall economic well-being. Unlike previous papers which examined these issues, the model developed in this paper allows the return on reserves to equal the return on government securities, which is less than the prevailing return on storage. Equally important, this model also considers how deficit financing changes the impact that paying interest on reserves has on the economy. I show that the number of steady state equilibria is equal to, or greater than, the number that arise when no interest is paid on reserves. Consequently, the level of economic indeterminacy is equal to or greater than in an economy without interest payments. When the level of indeterminacy is the same, then economic volatility is reduced with the introduction of interest payments. However, when greater indeterminacy in the interest-on-reserves economy exists, then there also exists greater volatility. In addition, paying interest on reserves can be welfare enhancing under certain conditions. When it is not, an appropriate expansionary open market operation can sometimes, although not always, offset the welfare losses associated with interest payments. Finally, under a narrow set of conditions, unpleasant monetarist arithmetic may also obtain.
|Date of creation:||02 Feb 2007|
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